Under the (Ontario) Securities Act (the “OSA”), any person in a “special relationship with an issuer” (e.g., insiders, senior management, directors, and advisors) is prohibited from disclosing material non-public information, i.e., “tipping”, subject to one notable exception: where doing so is “in the necessary course of business” (the “NCOB Exception”). Unfortunately, this exception is not further defined in OSA, and there have been few regulatory decisions – and perhaps even fewer cases – clearly delineating when such “necessary course of business exception”. The resulting uncertainty has always been a source of discomfort for management and advisors alike.
Fortunately, the Ontario Capital Market Tribunal’s recent decision In the Matter of Michael Paul Kraft and Michael Brian Stein (Kraft) sheds critical light into when tipping may be permitted relying upon the NCOB Exception.
What Happened in the Case
In Kraft, the chair of a company that produced medical cannabis shared drafts of a lease and option to purchase agreement with a former company consultant. The documents were part of a planned expansion in anticipation of the legalization of recreational cannabis. Kraft, the chair, had not pre-discussed with management his intention to share the documents but said that he wanted the consultant’s expert opinion on the real estate transaction. At this point, the documents were nearly finalized, and the board approved the transaction a few days later.
One day before the transaction was announced, the former consultant purchased 45,000 shares of company stock and then sold the shares immediately after the announcement, earning a profit of nearly $30,000. The tribunal concluded that this amounted to insider trading. In addition, despite Kraft’s attempts to argue that his disclosure was made in the necessary course of business, the Tribunal ultimately determined that Kraft’s sharing of documents constituted unlawful tipping. In the process, the tribunal provided some key guidance regarding application of the NCOB Exception going forward.
Interpreting and Applying the NCOB Exception: Focus on Necessary
The Tribunal started off the interpretation of the NCOB Exception with a reminder of the reason underlying the prohibition on tipping. The sharing of material non-public information, it noted, is restricted “to ensure that everyone in the market has equal access to and opportunity to act upon material information.” Bearing that in mind, the Tribunal noted that the exception should be interpreted and applied “reasonably narrowly” to avoid undermining the purpose of the prohibition.
To the tribunal, a key feature in narrowing the application involved emphasis on the word “necessary.” The Tribunal noted that this language “elevates the requirement beyond a mere business purpose or business rationale” and, as such, should be distinguished from what may be “in the ordinary course of business” [emphasis added]. Saying that the disclosure must be necessary, according to the Tribunal, means it must be essential, indispensable, or requisite. In this case, although the disclosure was made for a business reason—so that Kraft could get thoughts from a trusted friend and business colleague—the reason was not necessary in the course of the company’s business.
In addition to the emphasis on necessity and lack of prior consideration, the Tribunal’s decision included other critical lessons on the application of the NCOB Exception:
- The Standard is Objective. Kraft tried to argue that the Tribunal should apply a subjective standard to the NCOB Exception and consider whether the tipper believed in the necessity of the disclosure. However, the Tribunal determined that, even if the tipper had an honest, good faith belief in the necessity of sharing the information, that was irrelevant. The determination regarding application of the exception should be made on an objective basis. This is consistent with past rulings of securities commissions (which we have written on) that hold tipping to be a strict liability offence — i.e., no actual damage or consequence needs to be made out by the regulator for a finding of liability.
- Lack of Process and Diligence Was a Factor. The Tribunal found it relevant that Kraft did not consider whether the disclosure was in the necessary course of the company’s business before making that disclosure. This suggests that a company or actor within a company may be able to justify the NCOB Exception more effectively if they create a paper trail showing that they have considered the necessity of disclosing material non-public information before actually making the disclosure. For instance, evidence of board or management discussions, documentation identifying the purpose of the disclosure, and possibly a consulting or other agreement with the tippee defining their relationship with the company and imposing confidentiality obligations could help demonstrate that the actors involved attempted to respect the purpose of the tipping prohibition and work within a narrow exception.
- Additional Contractual Provisions May Be Advisable. In any agreement or document among the company and potential tippee, companies may want to include restrictive covenants such as those making any tippee subject to a trading blackout (similar to management and boards) since irregular trading can often be the impetus for regulatory scrutiny.
- Business Necessity May Belong to Someone Other Than the Issuer. The Tribunal noted that the phrase “in the necessary course of business” does not specify that necessity is restricted only to the issuer. While, in this instance, the tipper was arguing that the disclosure was necessary in the issuer’s business, the Tribunal noted that the exception need not be so limited, allowing for the possibility that the exception be allowed when disclosure is in the necessary course of the tipper’s (or someone else’s) business.
- The Burden of Proof Lies with the Tipper. While the Staff alleging the violation bear the burden of proving the elements of a tipping violation, the tipper who wants to assert the NCOB Exception as a defence must prove that the disclosure satisfies the requirements objectively.
Guidance Going Forward
While this decision provides some much-needed guidance on the NCOB Exception, it does beg a number of questions of how its lessons can be addressed in practice. If you have concerns about how this could apply to a current or future situation, a member of our business law group would be happy to discuss.
 In The Matter of Michael Paul Kraft and Michael Brian Stein reasons and decision, (Subsection 127(1) of the Securities Act, RSO 1990, c S.5), paragraph 267.